Setting Rate and Return Assumptions Is Tough

In the Milliman Pension Funding Index (PFI), released in January, under an optimistic forecast with rising interest rates (reaching 4.55% by the end of 2017 and 5.15% by the end of 2018) and asset gains (11.2% annual returns), the funded ratio would climb to 92% by the end of 2017 and 105% by the end of 2018. Under a pessimistic forecast with similar interest rate and asset movements (3.45% discount rate at the end of 2017 and 2.85% by the end of 2018 and 3.2% annual returns), the funded ratio would decline to 75% by the end of 2017 and 69% by the end of 2018.  

However, Jason Shoup, senior portfolio manager and fixed income strategist with LGIMA, believes sponsors should remain somewhat wary.

“What we’re contending with is an expectation of only modestly improved growth in the U.S.—and an outlook that has fatter tails to it. As a result, we have a rate outlook that has much more risk,” Shoup says. “Through the lens of a pension administrator and pension plan, you really need to be ready to act here, and you need to be poised in thinking about these issues. On the one hand, we may be seeing the highs of the market in terms of where rates can go right now. On the other we may be seeing the beginning of real normalization.”

Shoup adds that uncertainty about federal policies injects a new risk factor into considerations about rates. “The new administration may succeed in extending the current business cycle,” he speculates, pressuring rates higher over time, “but the possibility that the policies fail to live up to expectations, at least in some areas, seems remarkably high and argues for some degree and caution about the U.S. outlook.”

Shoup further expects there to be “quite a bit of uncertainty with respect to how high rates can go, and once again on the other side, if you have a misstep from the administration on corporate tax reform, on trade, on immigration, it’s quite possible that you have significant downside risks as well.”

NEXT: Market volatility should inform de-risking strategies  

A recent report from Northern Trust, which surveyed 100 investment managers, found that 78% anticipate inflation to increase throughout 2017, a large increase from the previous quarter’s 47%.

Still, Mark Meisel, senior investment product manager of the multi-manager solutions group at Northern Trust, believes managers will not actually see inflation increase dramatically over the course of the year—increasing the likelihood of a slow and steady rate picture.

“If I were a participant and I saw the results, I would be making sure that I have enough allocated to asset classes that do OK in a rising rate environment—not dramatically rising rates—but a slow rising rate environment, and one where inflation is beginning to have an impact again,” he says.

Meisel recommends real asset classes, including real estate investment trusts (REITs), Treasury Inflation Protected Securities (TIPS), and the global listed infrastructure. However, he warns that while commodities can offer protection from inflation, they also have high volatility.

“That may be something that, depending on the risk tolerance of the client, they may not want to invest in,” Meisel says. “Some of these other real assets I think would be important to have within a well-balanced portfolio.”

A related State Street Global Advisors market outlook report for 2017 found that forward return expectations for equities are less than 5%, while expectations for fixed income (post-inflation) came in between 1% and 2%.

Lori Heinel, deputy global chief investment officer for State Street Global Advisors, believes that because of this, most plan sponsors will have a tough time setting expectations during 2017.

“Think a lot about volatility management, because in an era of lower returns, higher volatility can be a big problem,” she says. “Also, look at things like illiquid assets, whether it be private equity and private real estate or infrastructure, or other kinds of low correlation assets.”